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The Timing Effects of
FOMC Directives
An Evaluation of Monetary Policy and the Influences over Financial Markets
Economics Thesis
Hartwick College
Adam Gabrielsen
Advisor: Dr. Laurence Malone
Spring 2014
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1. Introduction
The shorter run directives of the Federal Open Market Committee (FOMC) reflect the
long run goals for the Unites States economy. The release of information by the FOMC explains
the rationale for a particular policy stance. Monetary policy decisions are made in the interest
of promoting maximum employment, stable prices and moderate long-term interest rates. This
paper examines the Federal Reserve’s response to monetary policy looking specifically at the
role of the federal funds rate. Further, the paper aims to critique policy directives by examining
theoretical frameworks that offer insight on the effectiveness of monetary policy in the
financial markets by examining the timing and lag effects of the FOMC informational release
dates.
The recent financial crisis illustrated the importance of understanding and adapting
alternative methods for implementing monetary policy. The United States Central Bank has
suppressed discount rates near zero, hovering above the lower bound. Termed unconventional
policies, these decisions involve the transparency of announcements and the expansion of the
Central Bank’s balance sheet through purchases of securities (Jones and Kulish, 2013). It was
hoped that these unprecedentedly low rates would positively influence expectations; lower
borrowings costs and stimulate consumption and investment spending.
To study the effectiveness of monetary policy, this paper evaluates monetary policy
decisions that were made from 2003-2013. In researching the financial markets impact, the
analysis examines the time lag effects of the FOMC directives and the transparency of
information.
The paper is organized as follows. Section 2 is dedicated to a literature review which
considers how other economists have interpreted similar research questions. Section 3
contains the fundamental overview for the FOMC and explores popular theoretical frameworks
that policy makers use to craft directives. Section 4 presents the unconventional policy in terms
of the policy directives of the central banks. Section 5 elaborates on the Taylor Rule and the
role it plays in policy making. Section 6 elaborates on the timing and lag effects of FOMC
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directives and the influences that are casts over financial markets. Section 7 provides a
summary of the findings and concludes.
2. Literature Review
There is a vast and growing academic literature on monetary policy and its implications
in the recent recession. Thus, I organized the publications into three categories for analysis.
The first considers an optimal monetary policy under unconventional directives and examines
the structural implications. The second examines the theoretical framework that the FOMC
utilizes when making and evaluating decisions. The third takes into account the effects that
FOMC policies have on financial markets, which can be decomposed to study the timing and
information lags associated with the transparency of the central banking.
In the analysis surrounding monetary policy it is clear that short term rates can be seen
as a method of influencing long term rates (Jones and Kulish, 2013). The central bank’s
objective is to maximize its expected utility over the monetary policy horizon. Thus, to evaluate
the optimal directives, policy makers must take into account the price index, output and
expectations for instantaneous shocks (Romaniuk, 2007). It is important to identify an optimal
monetary policy because of the impact on the future state of the economy and because of the
direct influence that these policies have on household’s expectations (Orlik and Presno, 2013).
Bernanke and Mihov’s (1998) results indicated that no single model of policy
measurement is optimal, and there is considerable evidence that the Fed’s regime and goals
change over time. Further, it is important to understand the economy’s behavior in the context
of changing policies regimes. The transition from one policy to another is relevant and
practical; policy analysis should encompass anticipated structural changes that take into
account changes in informational transparency (Jones and Kulish, 2013).
The 1980s and 1990s have been characterized as the great modernization in the United
States Federal Reserve policy. Recessions occurred less frequently with faster recoveries as a
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result of more predictable policy and consistent focus on price stabilization (Taylor, 2013).
More recently the Federal Reserve deviated significantly from the type of policy that had
worked so well when the Fed previously held interest rates unprecedentedly low. This can be
observed during the 2003-05 period, did not return to a more normal policy (Taylor, 2013).
Williams concluded the justification of the recently unconventional policy can be attributed to
higher degrees of uncertainty and an optimal policy model should include a measure of this
effect. However, as recommended by Milton Freedman, adjusting to a steady money growth
rate rule would be more beneficial when interest rates are near the lower bound. Rule-like
policies, focused on interest rate responses, were regarded as predictable characteristics of
policy which lead to targeted inflation during the onset of the great modernization (Taylor,
2013). And, as Taylor (2013) points out, it is under uncertain times that predictable rules are
needed the most.
Simple policy rules have received attention as a means to push towards more effective
and transparent policy (Orphanides, 2001). Meade and Thornton’s (2010) results concluded
that the Phillips curve framework appears to have been significantly less important in actual
monetary policy making than in canonical macroeconomic models. Gallmeyer, Hollifield and
Zin (2005) discover generic equivalences in interstate rate policy rules. Research suggests long
term interest rate rules share desirable properties of Taylor rules (Jones and Kulish, 2013).
Based on the expectations hypothesis, McCallum developed a rule which contrasts with the
interest rate policy rule proposed by Taylor, and has more significant results when dealing with
lagged interest rate effects. However, it is difficult to make direct analytical comparisons
between Taylor’s and McCallum rules. Taylor rules have received attention because the
demonstrated results of the simple rule accurately described the behavior of the federal funds
rate (Orphanides, 2001). The FOMC has been known to base policy positions on the
recommendations of Taylor rules, and various versions of the rule became integrated into
models and policy analysis used by Janet Yellen as well as other members of the committee
(Asso, Kahn and Leeson, 2007). Additionally, it is generally agreed that the central bank’s
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optimization program should be considered a careful mixture between the price index and
output (Romaniuk, 2007).
The Fed has begun to implement forward guidance to influence expectations of short
term rates (William, 2013). Through forward guidance, the FOMC provides an indication about
the future stance of monetary policy. From 2003-2005, the Fed initiated a phase of policy
reversal where interest rates were held abnormally low and continued throughout the period
of the securitization of mortgages and other debt interments (Taylor, 2013). In late September,
2008 the Fed helped stabilize the financial systems by providing liquidity though increasing the
supply of reserve balances. Following the panic of 2008 liquidity needs decreased, although
instead of returning to a more normative approach to stabilize the financial markets the Fed
continued to expand its balance sheet. Termed Quantitative Easing, the Fed undertook large
scale purchases of mortgage-backed securities and long term treasuries. However, Taylor
(2013) concludes that an absence of these purchases, specifically during Q1 and Q2, would have
driven reserve balances back to conventional levels seen in the early 2000’s. More so, Taylor
(2013) explains the Fed argued that the rational for Quantitative Easing can be justified by the
negative nominal short term rate that policy models have suggested. Rates have continued to
hover around the zero bound, and Quantitative Easing can be seen as directive of recent policy
decisions. Further, the expansion of reserves implies that the Fed must mandate short term
rates by declaring what interest rate they will pay on their reserves (Taylor, 2013).
When the Federal Reserve and other central banks rely on unconventional balance
sheet policy tools, uncertainty regarding the effects of policy actions is relevant. Evidence
suggests, however, that these policies have reduced long term interest rates (Williams, 2013).
Uncertainty associated with fiscal, regulatory and international policies justify a change to a
more rules-based policy that would lead to improved economic performance through
stabilization and predictability of future policy (Taylor, 2013). It is difficult to quantify
uncertainty in terms of balance sheet effects resulting from policy; however evidence is
suggestive that conventional policy reduces uncertainty (William, 2013).
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There has been much scrutiny regarding the timeliness of the release FOMC
announcements. During the Greenspan regime, the FOMC committee argued that any release
of policy directives would increase volatility, produce unintended consequences, and force
early commitment for particular stance between FOMC meetings and announcement periods
(Belgonia and Kliesen, 1994). Further, increased transparency would impair the ability to
conduct monetary policy during intermeeting periods. However, sophisticated market
participants were able to exploit this delay by examining more complex aggregates, which
average investors were blinded to (Belgonia and Kliesen, 1994). Results indicate that the
release of minutes induces higher than normal volatility and trading volume across all asset
classes, but also show that the FOMC minutes provide market-relevant information (Rosa,
2013). Belgonia and Kliesen (1994) found evidence; however that indicates interest rate
responses are linked to the news in the directive rather than to the timing of the directives
release. This may help to explain why the FOMC has made an effort to increase the
transparency by releasing information in a timelier manner (Rosa, 2013).
3. FOMC Overview and Theoretical Policy Frameworks
The Unites States Congress mandated the objectives of the Federal Reserve to reflect
maximum employment and price stability. The dual mandate of the Federal Reserve is to be
separate from political influence; additionally the directives that are mandated are focused on
reducing business cycle shocks by maintaining consistent employment and controlling
inflationary pressures. To effectively manage unforeseen shocks in the business cycle, the
FOMC objectives can be boldly defined as expansionary and contractionary policy. Respectively
these goals correspond to either increasing or decreasing the money supply to influence
interest rates. Policy expansion leads to lower interest rates and increases in investment
whereas contractionary policy acts as its reciprocal.
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Figure 1
Figure 1 identifies the dual mandate of the Federal Reserve, by including unemployment
numbers and the consumer price index graphed against the discount rate from January 1, 2000
to December 2010. Prior to 2008, the decreasing discount rate was associated with relatively
stable inflation and the economy experienced near perfect employment, shown by an
unemployment rate of about 5%. The increase in the fed funds rate in early 2006 also pointed
out large deviations in the consumer price index, which was attributed to an increase in energy
prices (FOMC Minutes, Fall 2005), while unemployment seems to remain on trend.
In July 2008, a shift in policy directives led to a drop in the discount rate from its Target
of 5¼ %. Shortly thereafter higher commodity and energy prices created inflationary pressure
[FOMC Minutes, September-August 2008). From December 2007 through October 2009, the
unemployment doubled from 5% to 10%. Unemployment changes of this magnitude were last
matched by the recession in the 1970’s. Nevertheless, the rapid growth in the United States
economy in the mid 2000’s would justify the stagnated discount rate August 2006 to August
2007. As Taylor (2013) elaborates, there has been much debate regarding the magnitude to
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which these low interest rates accelerated the housing boom. The expansion that predates the
Great Recession, which according to the NBER extended for seventy-three months from
November 2001 to December 2007, was one of the longest expansionary periods in modern US
economy. To reiterate, overstated expansionary times often call for contractionary policy
responses.
Figure 2
Figure 2 point out the effective federal funds rate and the RGDP. The leftward shaded
area represents the eight month recession lasting from March 2001, and ending in November
2001 (NBER, 2014). Preceding the recent recession, the Fed began to decrease the fed funds
rate, which supports the argument that central banks have superior information and are able to
adjust policy to best combat contractionary indicators. The discount was held under two
percent, where it remained until December 2004. This period ushers in the beginning of the
housing boom, where low interest rates enabled borrowers with riskier credit histories to take
out home mortgages, effectively exacerbating household debt. The expansion of high risk
mortgages coincides with a period for market participants to capitalize from very high returns
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on the securitization of debt instruments. The housing boom was no doubt a major explanation
for the rapid economic expansion, as noted by the simultaneous growth in real GDP and the full
range of economic activity spawned by new home construction. In July 2006, it is evident that
the central banks cognizance of the economic growth provides firm reasoning for stabilization
in the fed funds rate. The contractionary pressure by the Fed supports the notion that central
banks have far superior information than market participants. The FOMC targeted and
maintained an effective federal funds rate of 5 ¼ % for the following thirteen months. From
July 2007 to the December 2007, just before the official onset of the recession, the fed dropped
their discount rate by one percent. Even more interesting, this window also coincides with the
period just before the collapse of Lehman Brothers and Bear Stearns.
An impressive literature works to uncover precise relationships between the objectives
of monetary authority and how it influences aggregate economic activity (Gallmeyer, Hollifield
and Zin, 2005). This paper considers three macroeconomic frameworks which are believed to
influence policy directives; the Taylor rule, The McCallum rule and the structure of the Phillips
curve. Additionally, an evaluation of theoretical policy tools may be difficult to interpret if data
other than what was available at the time of decision making is not used, academic economics
agree that it is equally important to evaluate historical policy using the framework and data
that policy makers used when crafting policy. The latter, has been investigated by Meade and
Thorton (2010), who assess the role the Phillips curve framework played in Federal Reserve
policy making. The concept of the Phillips curve documents an inverse relationship between
unemployment and wage inflation by relating the output gap, or deviation of unemployment
from its natural rate to present or expected future inflation in the form of expectations (Meade
and Thorton, 2010). However, despite the significant role of the framework has played in
macroeconomic theory, Meade and Thorn conclude that the Phillips curve appears to have
been significantly less important in actual monetary policy making than previously suggested.
Based on the results of Meade and Thorton (2010), a further analysis of the Phillips curve will
be omitted.
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Secondly, a paper by John McCallum in 1994 (Gallmeyer, Hollifield and Zin, 2005)
showed that elaborating on the expectations hypothesis model in conjunction with a monetary
policy rule that uses a measure of interest rates which is more sensitive to risk premium on long
term bonds, results in equilibrium interest rates that more accurately capture the empirical
results of the expectations hypothesis alone. Data required to examine these relationships
requires high frequency financial market information and results provide an attractive
perspective for monetary economists.
Lastly, the Taylor rule supports the contention that policy directives should be based on
a systematic response to incoming information about economic conditions (Asso, Kahn and
Leeson, 2010). The rule was first introduced in 1993, and was based on economic conditions
from the late 1980’s into the early 1990’s. Since the rule was brought to light, it has frequently
been used as a reference and arguably as a basis for FOMC decisions. It is important to note
that the Taylor Rule differs from the McCallum’s rule by requiring more slowly gathered
macroeconomic information, as opposed to high quality financial data available in real time.
The Taylor rule will be further decomposed in section 4 as per the results of Gallmeyer,
Hollifield and Zin (2010), whom conclude that Taylor rule results were more robust than the
competing McCallum rule.
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Section 4 Unconventional Actions of Central Banks
Figure 3
From July 2006 to July 2007, the Federal Funds rate floated around 5 ¼ percent, a target
rate that all committee members agreed upon at the June 27-28, meeting, despite the
overwhelming uncertainty of the housing market. The June minutes were released three weeks
later, on July 19th. However by August 2007 the fed funds rate had began to decline to 5%. The
Committee meeting on August 7th showed no signs of adjusting the Fed funds rate and insisted
on maintaining the 5 ¼ % target rate. Following the meeting the committee would then engage
in two conference calls on August 10th and 16th.
"Developments in financial markets since the Committee's last regular meeting have increased
the uncertainty surrounding the economic outlook…the Committee in the immediate future
seeks conditions in reserve markets consistent with reducing the federal funds rate to an
average of around 4-3/4 percent" (FOMC Minutes, September 2007).
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The drastic change in stance was the result of unexpected worsening in the housing
market, declines in consumer confidence and volatile financial markets. The fed funds rate in
September 2007 was 4.94%, and would continue to decline until May 2008, where the Fed
Funds rate of 1.98 % matched closely with the committee’s revised target of 2 %.
“At its August meeting, the Federal Open Market Committee (FOMC, 2014) kept the
target federal funds rate unchanged at 2 percent” (FOMC Minutes, September 2008). However,
the minutes from the September 16, 2008 meeting made clear observations of the consistent
worsening of the labor markets, industrial production and motor vehicle assemblies, which
resulted from a sharp decline in August car sales. This corresponds to a lack of confidence and
more conservative consumer spending. However the committee seemed optimistic based on
the easing of monetary policy and yet despite their confidence, declining economic
performance had paved the way for what was to be called the recession. The RGDP had
declined from $14,895 billion dollars in July 2008, to $14,574 billion dollars in October. That
was followed by another decline of over $200 billion dollars in January 2009.
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Figure 4
The monetary policy directive from the September 16, 2008 meeting states that “The
Committee in the immediate future seeks conditions in reserve markets consistent with
maintaining the federal funds rate at an average of around 2 percent." (FOMC Minutes,
September 2008). The economy continued to face trouble in the financial markets, labor
markets, housing markets and worsening credit conditions. Yet the committees’ optimism
surrounding the potential growth of the economy can be justified by loose monetary policies.
Along with business cycle indicators, such as investment and inventory, the labor market had
worsened considerably. The committee meeting on October 28-29, 2008 indicated the FOMC’s
stance for further monetary easing "The Federal Open Market Committee has decided to lower
its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this
action in light of evidence pointing to a weakening of economic activity and a reduction in
inflationary pressures” (FOMC Minutes, October 2008). Uncertainty surrounding the financial
markets in late 2008 can be attributed to the downfall of two major investment banks, Lehman
Brothers and Bear Stearns. The collapse of these institutions would lead to devastating
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economic and financial effects for households as well as investors both suppressed consumer
confidence, and plummeting confidence levels played a critical role for policy makers as they
were scrutinized by academic economists for their decisions.
Six weeks later, during the December 15-16 meeting, “The Federal Open Market
Committee decided today to establish a target range for the federal funds rate of 0 to 1/4
percent.” (FOMC Minutes, November 2008). The directives taken by the FOMC led to an
effective federal funds rate in December of 2008 of 0.16%, the lowest rate in the history of the
United States. More so, the targeted Fed funds rate of 0.16 % marks the lowest rate since 1954
and 1958, where the rate hovered around 1%, although only for a brief period in each year.
Neither policy makers, consumers nor market participants had experience in dealing with these
astonishingly low rates and may have feared the consequences of a further decline in the fed
funds rate. In response, there was followed by a massive expansion of the central bank’s
balance sheet, a cohort of economists consider if the these unprecedented rates were
implemented so the central bank could afford the quantitative easing which was taking place.
However, this paper only acknowledges the concept and thus dissents from the idea. Near the
worst part of the recession, consumer confidence and extremely poor business cycle indicators,
in addition to providing liquidity to markets, justifies the astonishingly low fed fund target rate.
“Since the Committee's last meeting, labor market conditions have deteriorated, and the
available data indicate that consumer spending, business investment, and industrial production
have declined. Financial markets remain quite strained and credit conditions tight. Overall, the
outlook for economic activity has weakened further.” (FOMC Minutes, December2008)
The minutes from the September through December, 2008 meeting reveal the initiation
of large scale purchases of agency assets, mortgage backed securities and long term Treasury
securities. Unprecedented economic times sometimes call for unusual and extreme responses,
and throughout this period the Federal Reserve employed unconventional policy to sustain
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economic growth and stabilize prices. Following the worse economic and financial downturn
since the Great Depression, the recent financial crisis has maintained interest rates near zero
for most of the past five years. At this lower bound, literature examines alternative
instruments for conducting monetary policy (Jones, Kulish, 2013). Termed unconventional,
these actions refer to the expansion of the central bank’s balance sheet through purchases of
financial securities or by adjusting decision transparency to influence expectations. After the
panic in the fall of 2008, the Fed began to “conduct unconventional large scale asset purchases
called quantitative easing” (Taylor, 2013). As Taylor (2013) remarks, the Fed stepped far
outside traditional boundaries, which may supplement consumer uncertainty throughout these
unconventional times.
Figure 5
The massive increases in reserve assets for Central Banks correspond to when interest
rates were held near the zero bound. Economists have pointed out, based on policy guidelines
that the fed fund rate should have been below zero for much of the period between 2009 and
2011. It is implausible for the fed fund rate to exist below zero; which articulates the argument
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for massive quantitative easing. In the defense of policy alternative, Williams (2013) argues
that increasing the Fed’s balance sheet to influence economic conditions is in accordance with
his view of expansionary policy. More importantly, businesses and consumers alike fail to take
advantage of reduced borrowing costs. There is both a recognition lag and negative consumer
confidence at work. Borrowing costs at these low levels should induce higher levels of
borrowing, increases in business start ups and help revive the housing market. This concern
has been addressed by academic and decision making economists, and the results support the
argument that would attribute a lack of confidence for both consumers and market
participants.
Moving forward, an increase in FOMC transparency involving direction and goals has
been used as a tool to inform consumers and influence investment expectations. It has been
argued that policy announcements should not be released immediately, which illustrates a
timing lag effect between directive releases and implementation. Keeping the public unaware
of short term policy objectives was once thought to be advantageous to the financial markets,
and reduces Fed accountability by reducing artificial influences on short term decisions. In
December of 2004, the FOMC decided to expedite the release of the meeting minutes and, in
doing so, reduce information time lags. Prior to December 2004, minutes were released three
days after the next committee meeting, compared to releasing the information three weeks
after the meeting, which thus reduced the informational lag by about three weeks (FED, 2014).
The FOMC argued that an early release of information would lead to unintended consequences
and precommitment as well as interest rate volatility. Fed minutes between September and
December 2008 indicates that intermeeting periods create expectations for market participants
and federal funds to exist significantly below targeted rates (FOMC Minutes, October 2008).
Empirical evidence supports the notion that future monetary policies influence household
investment by affecting the expected value of inflation (Orlik and Presno, 2013). Belongia and
Kliesen (1994) concluded that immediate announcement releases would not affect the markets
based on release dates, but based upon the quality of information. At the Institute for
Monetary and Economic Studies Conference in Tokyo, Japan former Chairmen Ben S. Bernanke
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noted “ Transparency regarding monetary policy in particular not only helps make central banks
more accountable, it also increases the effectiveness of policy” ( Bernanke, 2010). Further,
forward guidance not only aims to stimulate expectations but acts as mechanism for conveying
information that could eventually revert to more conventional policy making.
Looking more closely, it is imperative to identify structural changes that may influence
policy directives. There is considerable evidence that the Fed’s regime and goals change over
time. First, the constant change to the FOMC occurs at the first meeting of every year. The
FOMC is comprised of twelve members, the seven members of the Board of Governors of the
Federal Reserve System and the president of the Federal Reserve Bank of New York. The
remaining four members are made up of the presidents of the eleven remaining central banks,
whose service is based on a one year rotating term. The change in leadership can be associated
with the adjustment of policy. Despite continuous regime changes, a small minority of the
literature focuses on the actual policy making effects of the system, based on the rotation of
FOMC leadership. Thus, based on the lack of research, this paper assumes that the system does
work efficiently under the adjusted regime alterations and can conclude that structural change
refer to the release of information. Again this structural change in the release of information
last occurred in 2004, minimizing its effect on the time frame of this study.
Section 5 Examination of the Taylor Rule
Before the paper moves forward, it is important to note that due to the vast
quantity of variables and increasingly complex relationships that each indicator exerts over
others, it would be near impossible to identify an instrument which measures the effectiveness
of monetary policy that is absent from the smallest imperfection. In accordance with a growing
literature, this paper examines the Taylor rule to evaluate monetary policy directives from the
first quarter of 2003 to quarter one of 2013. This ten year period captures an array of
economic activity, including the prosperity of the housing bubble, to the largest financial and
economic collapse since the Great Depression and onto the uphill battle following the peak of
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the contraction. In conducting an analysis of the original Taylor rule, as proposed by John
Taylor in 1993 (Asso, Kahn and Leeson, 2010), outcome predictions will be compared to the
actual fed funds rate over an elongated time horizon to exemplify its accuracy. The framework
for the Taylor rule suggests that the federal Funds rate can be accurately explained by a simple
equation.
𝑟 = 𝑝+
1
2
𝑦+
1
2
(𝑝 − 2) + 2
Where p stands for the rate of inflation over the previous four quarters and y,
which corresponds to the percent deviation of real GDP from trend. Inflation is assumed to be
targeted at 2 percent annually, and real GDP to continue on its trend of roughly 2 percent
growth per annum, such that y = 0.
Additionally, justification for the accuracy of the Taylor rule in actual policy
making has been controversial. Fed policy officials remarked that “the parameters of the Taylor
rule ‘capture the stated intentions of virtually all Fed Officials’” (Asso, Kahn and Leeson, 2010).
Janet Yellen advocated for the accuracy of the Taylor rule when she indicated that she used it
to provide a “‘rough sense of whether or not the funds rate is at a reasonable level” FOMC
transcripts, January 31- February 1, 1995 (Asso, Kahn and Leeson, 2007). Nevertheless, Taylor
frequently visited with Fed staff and other economists to discuss and provide the FOMC with
various variations of his rule to advance the practice of central banking.
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Figure 6
Figure 6 represents an updated graphic, initially prepared Robert DiClemente of
Citi group, and revised by John Taylor in the fall of 2013. It illustrates the similarities between
the real effective federal funds rate and the Taylor rule predictor compared to an alternative
rule proposed by Janet Yellen in 2012. The Taylor rule is attractive to decision makers because
it prescribes a method of reducing business cycle fluctuations through a simple linear equation.
Further, the rule aims to minimize deviations in inflation relative to directives and output
relative to potential output. The data needed to perform the rule is equally understandable,
requiring only knowledge of current inflation and output gaps. Gallmeyer, Hollifield and Zin
(2005) concluded in a comparative analysis that the Taylor rule provided more robust results
than a competing McCallum rule. Moreso, the renowned Phillips curve framework will be
omitted as per the results of Meade and Thorton (2010) who concluded that the curve was
much less central to the formulation and implementation of policy. These findings were largely
the result of the stagflation that pained the economy in the late 1970’s and early 1980s.
Extremely high inflation and unemployment disrupted the framework of the model, rendering
the tradeoff between monetary policies useless.
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Section 6 Time Lag Effects and Financial Markets Impact
In terms of financial markets, efficient market theory states that all asset prices
are a reflection of the most recent and relevant information. Because markets are efficient,
prices represent a measure of information. This measurement is a culmination of aggregate
economic information at every level in the economy. There is a large literature which examines
FOMC decisions and financial market implications. Consistent with the efficient market theory,
Rosa (2013) concludes that FOMC minutes contain market relevant information. Further, Kurov
(2012) suggests “information communicated through monetary policy statements has
important business cycle dependent implications for stock prices”. Thus it is no surprise that
the valuation of assets will likely have major fluctuations in terms of trading volume and price
based on the release of FOMC directives. It is important to first separate two important aspects
surrounding price valuations in terms of FOMC meetings. Especially pertinent are the quality of
information and when the information is released, in regards to FOMC meeting dates and the
release of the information. Additionally, research suggests that during periods of economic
expansion, stocks tend to respond negatively to announcements regarding higher rates in the
future. In recessions, however, research indicates a strong positive reaction of stocks to
seemingly similar signals of future monetary tightening (Kurov, 2012).
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Figure 7
Figure 7 illustrates the striking correlation between the consumer confidence and the
federal funds rate from July 2007 through March 2009. Consumer confidence began to decline
in March 2007, while the fed funds rate would remain near its target of 5 ¼ % until August.
Holding all other economic indicators constant, this graph suggests that the FOMC was
negligent in regards to consumer expectations about the economy. This period marks the
onset of home mortgage defaults, further as consumers were unable meet their financial
obligations the Federal Reserve should have acted sooner. Decreasing the fed funds rate prior
to the later part of 2007 would have increased available funds and allowed for households to
meet their debt obligations. Ensuring liquidity earlier on would have possibly prevented
massive sell offs in the financial markets associated with increased consumer confidence. This
finding is further reinforced by the sell offs in the S & P 500 index in Figures 8 and 9. As the
FOMC decreases the fed funds rate, consumer confidence continues to decline. One possible
explanation of this is a lack of faith in monetary policy and its directives to relieve the economy
on a household scale. The conjoining decrease may also be attributed to higher levels of
uncertainty regarding the future of the economy.
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Figure 8
The following illustrates the relationship between the S & P 500 index and consumer
confidence, while highlighting FOMC meeting dates, conference calls, and informational
releases. The graph plots the timing lags associated with the release of the FOMC meetings
minutes from September 1, 2007 through March 1, 2008. This graph indicates increases in
consumer confidence surrounding FOMC meetings and unscheduled conference calls that took
place. This illustrates higher expectations for market participants regarding positive economic
outlooks in the FOMC minutes. In the three weeks following the September 18, meeting, the S
& P 500 shows an upward trend, despite a negatively trending consumer confidence. The
unscheduled meeting, which took place October 30-31, coincides with a positive day for the S &
P 500. Yet a negatively trending consumer confidence correlates to a massive sell off on the S &
P in the following three weeks leading to the release of the unscheduled meeting minutes. In
that time frame, the index dropped 110 basis points. The index does appear to increase when
the information on meeting minutes was released on November 20, indicating market
participants took favorably to the information. The unscheduled conference call on December
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6, and the following meeting on the 11th to a 60 basis point decline in the index from December
6th, 2007. It is important to note that the decline in the index following the December meeting
corresponds to the press release of the minutes being released in the latter part of the trading
day. The following day the index opened higher following over night positive news.
Unscheduled conference calls occurred on the 9th and 21st of January, preceding the
scheduled meeting for January 29-30, 2008. These unscheduled informational exchanges
increased the normal lag from three weeks to fifty one days, creating a great deal of
uncertainty, which is shown by a decrease in consumer confidence and additional 50 basis point
decline in the index.
Figure 9
Figure 9 is a time frame continuation of Figure 8, excluding the period from March 2,
through August 31, 2008. Figure marks the S & P 500 vs consumer confidence from September
1, 2008 to February 1, 2009, indicating when FOMC meetings that were both scheduled and
unplanned, conference calls and timing lag between informational release dates. Consumer
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confidence is shown to increase when FOMC meetings and unscheduled conference calls take
place, indicating market participants are hopeful that monetary policy directives will relieve
negative economic pressure. Following the excluded period between Figure 1 and Figure 2 the
index dropped to 56 basis pointed. Between the meeting on September 16 and the
informational release on October 7, 2008, the S & P 500 declined from 1213 to 996 basis points
as consumer confidence continued to decline. Unscheduled conference calls took place on
September 29, and October 7th and the October 7th meeting happens to coincide with the
release of September meeting minutes. The information from such was released on November
19, 2008, Three weeks after the meeting on October 28-29. Again correlating to a decrease in
consumer confidence, the index decreased from 1106 to 807 basis points between the span of
the conference call September 29th to the release of information almost seven weeks later. The
following meeting in December 2008 spanned two days, the 15 th and 16th, and over this period
the index jumped from 869 to 913 basis points. Throughout the following three weeks, the
index began to stabilize and closed at 890 basis points, coinciding with consumer confidence
trending upward.
It is important to note that conference call information is included in the minutes of the
following meetings, which lengthen the time lag effect. More so, the lengthened release of
information is associated with an increase in market relevant information that can be found in
the release. Consistent declines in the index, when examining meeting and informational
releases, indicates that market participants dissent with monetary policy regarding current
economic projections. Further, timelier releases could have yielded less drastic sell offs,
allowing market participates to make decisions based on the superior information that central
banks have access to. An increase in central bank transparency would increase consumer
confidence as well, keeping market participants privy to asymmetric information that would
have enabled an entirely different path of the economy that could have been measured using
the S & P index and consumer confidence. Also note that Figures 8 and 9 round index values to
the nearest whole integer.
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25
The Fed’s influence over financial markets is supported by the notion that central
banks have superior information surrounding the economic horizon. The FOMC statements are
designed, in part, to communicate information to market participants and thus the directives of
FOMC reflect the future path of aggregate economics indications. Based off the results of
Belongia and Kliesen (1994), who investigate the volatility as a function of announcement
effects, the results found evidence that the market responds more actively based on the quality
of the information. Indicating a more efficient rationale for interpreting the Feds
announcements corresponds to the path of economy and overall goals of monetary policy.
Section 7 Conclusion
Federal Reserve objectives, orchestrated by the FOMC, reflect maximum employment
and price stability by means of monetary policy. This paper examines the federal funds rate by
evaluating unconventional policies which explore the FOMC declining targeted federal funds
rate to the lower bound and the informational lags associated with the release of this
information.
Monetary policy actions used to combat the recession of 2001 were more successful in
meeting the objectives of their dual mandate than in the much more severe recession of 2008.
The Federal Reserve System has access to far superior information than non member market
participants, which is why FOMC minutes and directives have such meaningful financial market
impacts. This helps explain why consumer confidence and is an extremely important indicator
and predictor on macroeconomic conditions. Households and businesses back their faith in the
economy, in part, based on monetary policy objectives. This explains the importance for
examining the informational time lags associated with FOMC objectives and its respective
influence over markets. Informational release lags indicates the market participants’ dissent to
unconventional policies during the Great Recession. More so, this demonstrates how
important it is for the FOMC to track and utilize consumers’ confidence in the markets, as it is a
meaningful indication for expectations and speculation, the likes of which have significant
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26
impacts on equity indexes. The negligence the FOMC exhibited between 2006 and 2007, in
failing to identify and implement a rationale in a timely manner should have been corrected
and could have resulted in a drastically different economic outlook. The failure and delayed
response to identify key indicators may have had a leading role for unconventional monetary
policy. The first method, the expansion of the Fed’s balance sheet, and the second,
announcement effects to influence expectations, failed to meet the dual mandate of the
Federal Reserve.
An extension of this paper could capture quantitative informational time lags through
econometric models. Further analysis could quantify how the days between meetings and
reasoning release dates affect the trading volume and volatility of selective securities in
additional to exchange rates. The shadow of the United States Federal Reserve system also
opens up the possibility to evaluate results on an international scale. It will of course, also be
interesting and relevant to track the path of the central bank’s balance sheet, money supply
and the targeted discount rates over the near future to evaluate the objectives of the FOMC.
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27
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